4) Understanding and valuing options Flashcards
long call option
right to buy asset
short call option
obligation to sell asset
long put option
right to sell asset
short put option
obligation to buy asset
american option
exercised at ANY TIME prior to and including expiration date (more flexible, usually higher value)
european option
exercised only on the expiration date
how are position diagrams different to profit diagrams?
only show payoffs at option exercise price, they don’t account for the initial cost of buying the option or the initial proceeds from selling it
protective put
A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis.
involves holding a long position in the underlying asset (e.g., stock) and purchasing a put option with a strike price equal or close to the current price of the underlying asset.
aim of protective put
limit potential losses that may result from an unexpected price drop of the underlying asset.
to go long on a call option
investor hopes to benefit from an upward price movement in an asset. The call gives the holder the option to buy the underlying asset at a certain price.
go long on a put option
an investor who expects an asset’s price to fall—will be long on a put option—and maintain the right to sell the asset at a certain price.
a short position
is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price.
what is the benefit of a protective put
if you buy a stock and the price starts to drop, you can exercise put option to sell the stock at the higher price, even though present price is far lower.
Straddle (unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience significant volatility in the near term)
simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.
when is a straddle strategy popular
when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.
Determinants of the value of a call option
- Increases with the ratio of the asset price to the exercise price
- Increases with interest rate and the time to maturity
- Increases with the variance per period of the stock return multiplied by the number of periods to maturity
Determinants of the value of a call option:
2. Increases with interest rate and the time to maturity
a. When you own an option, you know that it will be exchanges for a stock at some point. Hence its equivalent to buying the stock but financing part of the purchase via a loan – the amount implicitly borrowed is the present value of the exercise price.
b. Hence higher interest rates mean that the present value of the exercise price falls.
c. Furthermore, the exercise price is paid at a later date. Hence a longer time to expiration increases the time premium.
Determinants of the value of a call option:
3.Increases with the variance per period of the stock return multiplied by the number of periods to maturity
a. Higher volatility of stock prices will allow more chances for the option to be exercised – more upwards potential.
b. You would like to hold a high volatility stock for a long time.
c. Hence an option written on a risky (high-variance) asset is worth more than an option on safe asset.
Determinants of the value of a put option:
o Cash spent purchasing put options is essentially interest payable, so holder of a put option has a cash disadvantage that depends on the level of the risk-free rate.
price of underlying asset increases
call option increases
put option decreases
price of underlying asset decreases
call option decreases
put option increases
strike price increases
call option decreases
put option increases
strike price decreases
call option increases
put option decreases
volatility of the asset increases
call option increases
put option decreases
volatility of the asset decreases
call option decreases
put option increases
what are the 5 variables that the value of an option depends on
- Higher Price of the underlying asset -> More valuable an option to buy it
- Lower exercise price -> More valuable the option
- Longer maturity date, the more valuable an option – especially when interest rates are high
- If stock price is below EP at maturity the call is valueless regardless of whether the price is $1 below or $100 below. But for every dollar that the stock P rises above EP, option holder gets an extra $1. Thus value of call option increases with the volatility of the stock P.
- A long-term option is more valuable than a short term option bc a distant maturity delays the point at which holder needs to pay the EP and increases the chance of a large jump in the stock P before the option matures.
why can’t options be valued using the discount rate?
it’s impossible to find the opportunity cost of capital as the risk of an option changes every time the stock price moves.
• The higher the stock price is relative to the EP the
safer the call option, although the option is always risker than the stock. The option’s risk changes every time the stock price changes.
are options riskier than stocks
yes
how to create downside protection for put options
Buying the share + buying a put option
–> if stock price rises above EP, option is valueless but you still get the gains from the investment in the stock
–> if stock price falls below EP, can exercise option and sell at EP
what’s the cost of insuring for downside protection for puts?
the amount you pay for the option
downside protection for call options
buying the share + buying a call option
–> is stock price rises above EP, can exercise call option and buy at EP
–> if stock price falls below EP, call option is valueless but you still get gains from investment
Fundamental relationship for European call options:
Put call parity
Value of call + PV of EP = value of put + share price
When does the put-call parity apply?
This relationship only applies if the option is held to maturity and hence does not hold for American options.
o if investors indifferent to risk:
expected return = risk-free interest rate
sellselling a straddle
investor aims to earn profit from low volatility in the market (graph is flipped)- gains when price isn’t moving much in either direction
